Thursday, November 17, 2011

Deficit fixing, Austerian style.

In the UK, the Labour government was heading for a deficit of £389 billion, which was simply unacceptable during a recession. It was obviously time to tighten the government's belt. So Labour was ousted and the new government promised austerity would solve the problem.

After £40 billion of budget cuts, the deficit is now projected to be...

... £412 billion.

Yes, that math is correct. Cutting spending by 9% of the deficit during a weak economy resulted in increasing the deficit by 5%. The reduced spending echoed through the economy - consumers had less money to spend - business took in less money - business expansion was reduced. Tax revenues didn't keep up with expenses and the deficit increased.

This outcome wasn't a surprise. Keynesian economic models predict a multiplier effect for reducing government spending. Indeed, this is why Keynesians argue for reducing government spending or increasing taxes during good economic times, when deficit spending can add to "irrational exuberance" of an overheated economy. Imagine if the Bush administration had cut the subsidization of mortgages in 2004 or increased taxes on capital gains from flipping houses as we came out of the prior recession. Without a housing bubble, some people on Wall Street (and Main Street) would have made less money, but we wouldn't have had a financial panic and crash that required a bailout. Everyone likes to forget the flip side of Keynesian ideas when they ridicule deficit spending during a weak economy.

Keynesian economists are held in low regard by the "Austerians" who control most policy these days. Austerian "common sense" is that households must tighten their belts in a recession and therefore so must the government. I've to to admit, it does sound like the kind of just and moral world we'd like to live in. But just because it would be nice for pi to equal 3 doesn't mean that 3r will get you the circumference of a circle.